Revising up sales target. We recently met the management of UMW which remains upbeat on the outlook of the company. Indications are that there will be an upward revision in vehicle sales target from 93,000 units to 96,000 units, up by 3.2%. The new target is still conservative in our view as we estimate that Toyota sales could touch 101,056 units in 2012,  up 14% y-o-y. For 2013, management will continue to bring in new face-lifted models which will see auto sales for the year for Toyota sustaining well to record a growth of 8.3% y-o-y. Moreover, its growing market share over the recent years  has also resulted in  UMW seeing higher revenue contribution from its after sales and used car businesses.

Honda's come back a threat?  Many  have  argued  that  UMW  benefited  strongly  from  the  absence  of competition  from  Honda,  which  had  halted  production  for  several  months.  While  we  concur,  the  recent numbers from Malaysian Automotive Association shows that sales of the Vios and the Camry has remained encouraging  despite  Honda  making  a  comeback.  UMW's  localized  Camry  bookings  continue  to  be encouraging, standing at 3,000 units with a two-month waiting period.

Eco  car  a  big  wild  card.  A  wild  card  that  could  see  Toyota  sales  propelling  further  is  the  possible introduction of its Eco car into its lineup after its launch in Thailand slated in 2013. Note that Toyota is the only major  eco  car  maker  that  has  yet  to  launch  a  vehicle  globally.  We  think  Toyota  is  holding  back  for  now pending the introduction of new policies by the Indonesian and Malaysian governments.

What the upcoming NAP will unveil? We think the upcoming National Automotive Policy (NAP) could likely be unveiled before year-end. We understand that most of the framework for 2012 has already been finalized. The upcoming NAP will focus on promoting green technology and a greener holistic system, from production to  processes  to  supply  chain.  This  means,  it  would  not  only  confine  to  just  hybrids,  but  also  conventional internal  combustion  engines  that  meet  multi-tiered  fuel  economy  and  exhaust  emission  targets.  Our  checks also  reveal  that  there  could  be  a  revamp  in  fuel  pricing  policy,  which  would  spur  sales  of  fuel  efficient vehicles.  While  many  automakers  are  banking  on  the  End  of  Life  vehicle  scrapping  policy,  this  will  not  be introduced  anytime  soon  until  the  industry  as  a  whole,  across  all  supply  chains,  has  been  completely reformed.  To  further  liberalize  the  auto  sector,  the  upcoming  NAP  is  expected  to  lift  the  freeze  on manufacturing  licenses  for  new  applicants  keen  in  manufacturing  models  below  1.8-litre  or  RM150,000, provided that they meet the  Enhanced Environmentally friendly Vehicle (EEV) standards, which is based on certain fuel economy standards. While this opens up competition, we reckon only a selected few will meet the EEV standards. 

Long term commitment to Petronas. In late June, UMW signed a MOU with  Petronas to set up a training academy that will help address the shortage of skilled Malaysian personnel in the  O&G and drilling industry. We see this as a step forward in forging a long term partnership with Petronas as the latter's major offshore drilling contractor. Currently, of all its three existing rigs, two are chartered out to Petronas. Our latest checks reveals that Petronas currently operates 14 rigs (13 in South East Asia and one in the Caspian Sea), of which two  are  owned  by  UMW  (Naga  1  and  Naga  3)  and  one  belongs  to  SapuraKencana.  The  lack  of  domestic players in O&G drilling field bodes well for local players such as UMW, which we see as a major beneficiary in the development of marginal oil fields where Jack-up drilling rigs specs are best suitable for. Rig utilization in South East Asia is currently at 80% compared to 72% last year. As for Jack-up rigs specifically, utilization has been hovering at around 78% over the past  three years globally and hence, we think rates would not be too highly priced.

+1 purchase option of drilling rig likely to be exercised. We see the likelihood of UMW exercising its +1 option for the purchase of an additional Jack-up rig for RM212m following its recent purchase of the Naga 4. The Naga 4 will be delivered by Feb 2013 and the +1 option, if exercised, will be delivered by July 2013. We understand that Petronas has three Jack-ups contracts with Rowan and Aban Offshore that will expire by end 2012 and this gives UMW a higher chance to rake in new contracts for its new drilling rigs. Even if there is a need for Petronas to use its rigs it could be under short term basis as they may prefer to lock in charters with UMW given that their rigs are brand new and could be used as a training field for their drilling academy.

Rights  issue  on  the  cards?  There  are concerns that UMW's  debt  rating,  currently  at  AAA,  will  be compromised given the high capex allocated over the next two years for the acquisition of its drilling rigs (if +1 option is exercised). UMW so far is allocating a capex totaling RM200m for the Camry localization and with the purchase of the two Jack-ups, capex over the next two years could average at RM800m per annum, 50% more  than  its  RM520m  average  per  annum  over  the  past  three  years.  However,  with  the  higher  income generated  from  the  drilling  assets,  we  foresee  that  this  will  improve  the  company's interest  coverage  ratio, which we expect to rise to 31x by FY13 from 17.8x currently. Hence, we see no immediate concern of UMW doing a rights issue exercise as it has ample room to gear up its debt further.  As of 1QFY12, UMW is sitting on a net debt pile of RM312m (net gearing of 7%) but we expect this to reverse to net cash as the sales of more  inventories  come  2H  will  improve  its  overall  cash  conversion  cycle.  UMW  tends  to  be  in  net  debt position during the 1H of the year due to inventory buildup and capex allocation. We expect the company to remain at net cash levels generating free cash flow in excess of RM1bn per annum. This proves favorable for investors on the likelihood of UMW dishing out higher dividends. We are still expecting a conservative  payout ratio of 50%, giving a dividend of 44.4sen for 2012 to yield at an attractive 4.6%. 

O&G division restructuring updates. UMW is currently undergoing a restructuring exercise to streamline its O&G operations. Management has recently disposed of its  fabrication business in Vietnam, and this will see further asset disposal of its non-core businesses such as trading of O&G equipments where margins are thin. As for its pipe manufacturing business, notably for its associate WSP, prospects continue to be challenging although  it  is  seeing  its  businesses  expanding  to  other  regions,  notably  to  South  America,  Middle  East  and Central Asia,  improving its total volume by 2.5% y-o-y.  The decision on whether to take up the privatization offer for WSP Holdings will be decided by end 2012. We believe UMW will likely be better off taking up the offer given that it has already recouped its investment costs totaling close to RM300m through dividends and profit  contributions.  Should  the  privatization  offer  for  WSP  be  exercised,  UMW  will  rake  in  a  total  cash  of USD13.6m at an offer price of USD3/share. Noting that the share price is still at USD1.7/share, there could potentially be a reduction in the offer price. As UMW does not own a majority stake in its pipe manufacturing businesses, its core focus will be on the upstream drilling segment and moving forward, we could be seeing more aggressive rig acquisition as the development of the marginal oil field progresses. Upon  the completion of  the  restructuring  exercise  of  its  O&G  division,  we  see  the  much  awaited  listing  coming  in  eventually, sometime in 2013-2014. As its O&G division has been in losses over the past few years, valuations from this division have yet to be priced in; hence, we are essentially valuing it for free.

Earnings upgraded. We expect UMW to post higher earnings q-o-q and y-o-y boosted by its auto division as q-o-q and y-o-y vehicle sales jumped by 30.1% and 40.1% respectively. Despite the calamities of events last year, UMW's margins continued to inch higher on the  EBITDA level, its highest since 2009 (FY09: 9%, FY10: 13%, FY11: 15%) and we expect margins this year to inch to record levels, thanks to  the weak USD against the  RM.  Furthermore,  this  will  also  bode  well  for  its  equipment  division  too  given  that  its  costs  are  also  in USD. In anticipation of the strengthening RM coupled by the economies of scale from the higher volume; we anticipate  that  auto  earnings  will  grow  by  24%  y-o-y.  We  have  been  very  conservative  in  our  margin assumptions  for  the  auto  division,  of  which  we  have  revised  up  from  14%  to  16%.  We  have  also  slightly nudged  up  our  oil  and  gas  EBITDA  margin  assumptions  to  18%  from  17%,  in  line  with  the  margins  it  had earned  the  previous  year.  All  in,  this  upgrades  our  earnings  for  FY12/FY13/FY14  by  14%/13%/9% respectively.  Our  earnings  estimates  of  RM1bn  and  RM1.17bn  respectively  for  FY12  and  FY13  (earnings growth for FY12 of 23% and FY13 of 13%) are higher  compared to consensus' RM858m and RM932m. We believe this is growth number is achievable, noting that back in 2010, UMW's earnings grew strongly at 38% y-o-y after recording vehicle sales growth of 12%, driven by 82% jump in earnings from Toyota. 

Foreign  interest  picks  up.  UMW's  earnings  potential  upside,  coupled  with  its  attractive  dividend  yield  has generated  a  lot  of  foreign  interest.  Foreign  shareholdings  have  increased  from  15%  in  1Q  FY12  to  22% currently. Its three months average trading volume for the stock has also spiked up 82%.

Maintain BUY at a higher fair value. In anticipation of earnings visibility coming from the O&G division, we peg UMW's O&G business at a higher multiple of 14x from 12x earlier. We see room for further upside for the stock, as our revised FV of RM12.07 plus its net dividend yield of 4.6% give a collective upside of over 28%. Our new FV implies a PE multiple of 12x, which is still below its mean of 13x since 2008. We maintain high conviction  buy  and  top  pick  in  the  auto  sector.  Since  we  upgraded  the  stock  back  in  February  2012,  it  has gained 40% to become the FBMKLCI's best performing stock, outperforming by the KLCI by 33%. 

Source: OSK